The tax-free money market fund industry continues to shrink rapidly, squeezing what had been a major source of short-term credit for municipalities and arguably leading to higher borrowing costs for state and local governments.

Tax-free money fund assets rose by $16.7 million to $326.9 billion during the week ended Dec. 20, according to ­iMoneyNet.

This marks a brief interruption of an unmistakable trend that began in early 2009.

Investors yanked $92.4 billion from tax-free money market funds in 2009, and an additional $71.8 billion so far in 2010, according to the Investment Company Institute.

The tax-free money fund industry, which ended 2008 with $489.3 billion in assets, has shrunk by a third in the past two years, to $325 billion.

The impetus behind the exodus of cash is no mystery: returns on the funds are too low for investors.

Money market funds behave like cash by investing only in instruments with supreme safety and liquidity. Yields on these instruments tend to shadow short-term low or no-risk interest rates, such as the Federal Reserve’s federal funds rate or short-term Treasury bill rates. Thanks to the Fed’s commitment to keeping benchmark interest rates near zero, these rates have been pinned to the floor for two years.

The Securities and Financial Markets Association swap index measures the average yield on a seven-day tax-exempt variable-rate demand obligation, which is the primary instrument tax-free money market funds buy. That index at its latest reading, on Dec. 15, was 0.3%.

That’s what the money market funds collect on their holdings. They then charge management fees on those returns, leaving an average yield of 0.04% for investors, according to iMoneyNet, despite most complexes waiving the majority of their fees.

“People are leaving the municipal money markets, and moving money into other places,” said Craig Mauermann, who manages the $921.5 million Marshall Tax-Free Money Market Fund for M&I Investment Management. “There have been a lot of people who have left the money market funds. They are reallocating from the panicked cash position from a couple of years ago.”

The drainage of cash from money markets alters the public finance landscape in some significant ways.

According to the Federal Reserve, at the end of the third quarter money market funds owned 11.6% of outstanding municipal securities, which is the lowest share since 1996. Their share peaked at 18.8% in 2008.

The shift of ownership of municipal paper from money funds to longer-term mutual funds matters because of the type of instruments these respective buyers hold. Mutual funds will typically hold bonds, while money market funds own floating-rate deals with either very short maturities or put features.

For better or for worse, rampant demand from money market funds prior to the deflation of the industry’s assets enabled municipalities to sell more variable-rate demand notes, revenue anticipation notes, and other short-term securities that gave municipalities flexibility to bridge cash-flow gaps and explore options other than long-term fixed-rate bonds. It is worth pointing out that the types of instruments money funds buy normally carry lower yields, bestowing lower borrowing costs upon municipalities.

JPMorgan analysts Alex Roever and Chris Holmes, in their 2011 outlook last month, pointed to several challenges the shrinkage of the money fund industry poses for municipalities.

With less demand from money funds, governments have had to resort to other types of buyers for Rans and other short-term notes, Roever and Holmes said, leading to higher borrowing costs.

The atrophying of the money-market fund space may also provide an explanation for why more arbitrageurs have not stepped in to help flatten the historically steep tax-exempt yield curve, they said.

This type of arbitrage typically entails borrowing from a money market fund at a short-term municipal rate. With so much less demand available from money market funds, it is harder to arrange this type of financing, constraining the arbitrage that facilitates so much buying on the long end of the curve.

Tax-free money market funds could easily cough up another $100 billion next year, Roever and Holmes said, bringing the industry’s share of municipal debt ownership to 8%.

Mauermann said it is common for money market funds to experience outflows toward the end of the year as clients need cash for various things like paying bonuses to employees or making annual pension contributions.

Fund managers anticipating these outflows usually try to hold on to cash, causing the SIFMA rate to bump up because managers are reluctant to tie up their money. Mauermann expects that rate to jump five to seven basis points at the next reading.

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